Chapter 6: Determination of National Income

Introduction

• Mainly discusses four models:

  1. Two-sector model
  2. Three-sector model
  3. Four-sector model
  4. Investment Multiplier and other multipliers

• Main focus is to explain the concepts of ex-ante and ex-post

• John Maynard Keynes - Father of Macroeconomics

• Keynes laid the foundation of important economic models during the 1930s Great Depression

Economy Models

Two-Sector Model

• Economy consists of households and firms
• Equilibrium occurs when Aggregate Demand (AD) and Aggregate Supply (AS) are equal
• Formulas:
  • AD = C + I (Consumption + Investment)

Diagram

• AS = AD -> 45-degree line
• Concept of injection and leakage

Consumption Function

• C = A + B(Y - T)
• A = Autonomous Consumption
• B = MPC (Marginal Propensity to Consume)
• T = Tax

Saving Function

• S = -A + (1 - B)Y

Equilibrium Conditions

• AD = AS
• S = I
• Injection = Leakage

Three-Sector Model

• Firms, households, and government
• Formula:
  • AD = C + I + G (Consumption + Investment + Government Spending)
• Circular flow includes three parts: Income, Expenditure, and Production

Tax Adjustment

• Significant role of tax and government spending
• AD = C + I + G
• C = A + b(Y - T)

Four-Sector Model

• Firms, households, government, and foreign sector
• Formula:
  • AD = C + I + G + (X - M) (Net exports)
  • Contribution of export and import

Circular Flow

• More parts in circular flow

1. Households provide factors of production
2. Firms provide factor payments
3. Households spend on products
4. Government transfers and subsidies
5. Export and import in the foreign sector

Multiplier

Investment Multiplier

• K = 1 / (1 - MPC)
• Change in Income divided by Change in Investment

Tax Multiplier

• Kt = -MPC / (1 - MPC (1 - t))

Foreign Trade Multiplier

• Kf = 1 / (1 - MPC + MPM)

Diagram

• Effects of Investment Multiplier

Concepts

• Leakage: Saving, tax, import
• Injection: Investment, government expenditure, export
• Concepts of ex-post and ex-ante
• Full employment, inflationary gap, and deflationary gap

Graphs and Curves

• Consumption curve
• Saving curve
• Aggregate demand and supply curves
• Inflationary and deflationary gaps
• Equilibrium points

Important Points

• Understanding every diagram is essential
• Various types of multipliers
• Circular flow in the four-sector model is crucial
• Understanding investment, tax, and foreign trade multipliers is very important

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Questions and Answers

Question 1: Formula for a closed economy? Answer: AD = C + I

Question 2: Formula for aggregate demand in the four-sector model? Answer: AD = C + I + G + (X - M)

Question 3: Formula for investment multiplier? Answer: K = 1 / (1 - MPC)

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